February 1994
Vol 17 No 6
The answer: THE RENT! The rent always comes first! That's a maxim that every successful landlord and investor must take to heart in order to continue to invest in and to expand an inventory of income producing real estate. We're just starting a new year and we've raised our rents to try to match the 2.6% inflation that the government admits to. We've also culled some weak renters by not offering new rental agreements for the coming year and are busy upgrading our tenant profile with those who have better jobs and more stable employment prospects. In this issue, we're going to take a look at the things people do wrong as property managers and what can be done to remedy them. And along the way we'll discuss ways in which more gross rent dollars can be collected and converted into net spendable income by reducing expenses and increasing overall gross income.
In the owner-occupied single family house market, values are set more by financing terms and market appeal than by economic performance, but, with investment properties, income is the key to all other profits. When setting value on income producing property, the net operating income is divided by the current capitalization rate to determine value. Thus, if a property were rented for $750 per month and the current capitalization rate were to be 10%, one might think that the value of the property would be $750 times 12 months, or $9000 divided by .10 to arrive at $90,000. But that isn't the true value. $9000 per annum is GROSS income. There might be additional income other than rents which we might add in. These could include late charges, lost deposits and Option consideration, pet and extra visitor charges, tenant improvements and upgrades. In larger properties such as apartments, mobile home parks and condominiums, parking and storage fees, utility charges, laundromat, rental furnishings and appliances, check cashing service, charges for lost keys, mail room services, etc. might be added to the rental income to substantially improve gross income.
From this, we'd have to deduct operating expenses. These could include a host of things such as management costs, salaries, repairs, utilities, taxes and fees, accounting, vacancy and credit losses, insurance. Year in and year out, these usually soak up a little more than half the gross rental income that would be generated if the property were occupied year around at market rents. It's a mistake to add in costs of financing and interest as an operating expenses, since this doesn't accurately reflect the economic value of the property based upon its performance alone, although it materially affects the benefit to the owner. More about this later. For now, let's re-do the arithmetic to find the value.
Beginning again with $9000 gross scheduled income, we'll add another $1000 for extra fees and lost deposits in our mythical example and deduct $5000 representing vacancies and operating costs referenced above. This will leave us with $5000 net operating income which when divided by 10% gives us a value based upon the income approach to value of $50,000. Why have we spent so much time on this? The management function is solely responsible for producing the income and controlling the costs upon which the ultimate value – and gain or loss upon sale – will depend. Without rent, there's not much value. But there's more.
INFLATION CAN DRIVE PRICES DOWN AS WELL AS UP . . .
Inflation affects the capitalization rate we use. A rational investor sets an investment yield based upon a variety of factors. Starting with our 10% above, when inflation is reduced or loan demand is diminished, lenders lower interest rates to attract new business. As a result, the returns available to investors in competing investments such as the bond and mortgage markets is reduced commensurately and cap rates are lowered. If our $5000 in net operating income were to be capitalized at 8% instead of 10%, the property value would rise to $62,500. If inflation were to drive the cap rate to 12%, the property value would fall to $41,667. The only way to offset this would be to increase net operating income to $6000 from $5000. Dividing $6000 by .12 still gives us a value of $50,000. Certainly, raising rents has a lot to do with this, but so does lowering costs. Let's take a look at each separately.
I like to raise all my rents at the same time as of February 1st. This is a period in Florida where seasonal rents are highest and when there's a lot of competition for housing. Furthermore, tenants don't like to move out in mid-term of the school year, so I get less turn over because of rent increases. My rental agreements all expire on January 31st of each year. Routinely, I try to match the inflation rate, but I also use rent raises to test the market and to motivate people to buy the houses they are renting. I notify tenants of pending rent raises the 2nd week of December and send them an agreement to either pay the rent or to terminate their tenancy effective January 31st. The form must be returned with their rent on December 31st. This way we both have time to make plans well ahead of the termination date. We each know where we stand for the coming year. It gives the tenant time to find new lodgings and makes it easier for me to estimate my tax position for the coming year and to make certain elections regarding incurring expenses in the current or following year. My departing tenants are obligated to help me re-rent the property upon move out and this gives me 30 days to find replacement tenants with their active help.
By using this rent raise scheme, I'm able to keep net operating income up with inflation on an annual basis while reducing vacancy losses, both of which help my 'bottom line' net operating income. In period of high inflation, such as we experienced in 1979 and 1980, my rent-raise letter built in 'installment increases' which allowed me to raise my rents every 4 months. The tenants saw this as being better than having a single large raise at the start of the year which would have created severe financial distress for them and vacancies for me. It also helped match my net operating income to inflating capitalization rates.
OPTIONS CAN BENEFIT BOTH OWNERS AND TENANTS . . .
There are lots of ways in which net operating income can be increased with 'low profile' rent raises which masquerade as 'leases with Options'. The most obvious benefit to the tenant is that a portion of the rent payment is counted toward the eventual down payment and purchase price. Thus, the tenant is able to build equity in the property. The landlord loses none of the benefits of ownership, but can charge a premium over market rents to increase cash flow. It wouldn't be unusual for someone with a $750 per month rental to add 10% for an Option, bringing the cash flow up to $825 per month. To induce this, the owner might offer $100 credit toward the purchase price once the tenant had accumulated sufficient equity to be able to qualify for a mortgage loan.
Let's say we're talking about a house current market value of $100,000 which might rent for $750. Bear in mind, the tenant will be buying the property as a 'user' who is more interested in the tax and 'user' benefits of ownership than in the financial return based upon net operating income. In this case, he or she will be looking mainly at the relationship of net mortgage payments after deductions for interest and taxes compared to the current non-deductible rents. By adding $75 per month to the rents and crediting $100 toward the payment, it would require about 60 months for the tenant to accrue $6,000 via his/her Option during which time there might have been no rent increases.
A feature of an Option is for the owner to hold the rents constant in return for the tenant's taking responsibility for maintenance, insurance and/or taxes – or any combination thereof. In the meantime, the owner would have experienced no vacancies and would have had increased net operating income by virtue of increased cash flow on the one hand and reduced costs on the other. Both parties would have benefited to a certain extent. Now let's look at some variations on this theme.
I once had a tenant who wanted an Option but didn't want to pay high rents. He did have $3000. I reduced the rent by $50 per month for 3 years and gave him an Option to buy at the appraised value at the end of the 3 year period. Here's how we calculated it. We were effectively losing $600 per year in rents for 3 years – or $1800. In addition, we were losing all possibility of rent increases over that period. On the other hand, he was assured of a stable rent within his budget for 3 years and the balance of $1200 that he'd paid in would count toward his down payment at the end of 36 months. He agreed to make all repairs to the property during his tenancy and we agreed to give him credit toward the purchase price for every capital improvement he made to the property which we approved of in writing. The only catch was that he had to make all payments on time and to adhere to the rental agreement for three years. If he left early, and found a replacement tenant acceptable to us, we agreed to give him back the $1200. During his tenancy he installed a fence and a patio, remodeled the kitchen for which we gave him a credit of $4500 against the down payment and purchase price. But then his marriage broke up and he and his wife both moved out suddenly without notice. This was an extremely profitable transaction for us.
In another instance, I was able to locate a potential fixer-upper which the owner was ready to give back to the lender. The problem was that he couldn't afford to move into another rental and nobody would give him any cash for his run down house. I moved his family into another vacancy and gave him rental credit for half of the $400 payment for 5 months ($200 X 5 = $1000) in return for a deed. I made up another $1000 or so in back payments and transfer costs and took title subject to the mortgage without any personal recourse. Then I advertised: 'ABSOLUTELY NO CASH DOWN PAYMENT NEEDED. SKILLED HANDYMAN CAN BUY WITH SWEAT EQUITY AND TOKEN PAYMENTS'. My new tenant paid $195 per month and added his rehab efforts in return for a one year Option to purchase at a price based upon estimated market value of the property in fully rehabilitated condition. I charged him $500 for the first month's rent to guarantee that he'd actually do the work, then paid it back to him less the $195 after he'd completed a specified amount of repairs according to a master schedule we worked out between ourselves. He got full credit for the $195 toward the purchase price. We repeated this each month until he bought the house. In effect, he was buying a ticket to his own parade. He improved the property, then got a new loan to buy it based upon the improvements he'd created. His accrued $2340 in rental credits was just enough for a new FHA loan.
Normally, a call Option on the purchase of a property nominally place the decision as to whether or not to buy the property into the hands of the person holding the Option. Of course this isn't always the case. Suppose I gave you the right to buy a property at an attractive all cash price. We'd both know that you'd have to find a mortgage lender who would approve you for a loan. If you failed to find a mortgage, you'd be unable to exercise your Option. And if the credit market trends were tightening when I sold you the Option, there would be little chance that you'd ever be able to buy the property. Of course, tenants don't always tell the absolute truth about their previous credit history. When this kind of person pays extra to lease with an Option, he or she more or less gets his or her just desserts for falsifying credit references in the first place. If they don't get a loan, it's their own fault. This is a pretty cynical approach. There's a more open way to transact business.
RIGHT OF FIRST REFUSAL OPTIONS OFFER BENEFITS TOO
Right of First Refusal Options leave the control over the exercise and timing of a sale in the hands of the seller. The Buyer can only buy if the Seller offers the property for sale. A buyer is thus gambling that the seller will eventually want to sell the property and takes the chance that he can meet the price and terms. Of course, these can be pre-negotiated, but it rarely happens. Why would a buyer ever enter into this kind of a transaction? To secure the right to remain in possession and control of a property over a long term when he can't buy it. Commercial establishments would find this especially beneficial. But so do home dwellers. Here's another case in point.
I've presently got a locksmith renting from me in a neighborhood in which there are few rentals and few sales. He and his wife grew up in the area and want to live there among their family and friends. They offered me $3500 for a of Right of First Refusal Option at the appraised fair market value of the house they were renting. I agreed to use the entire amount to make capital improvements and to upgrade the bath and kitchen so long as there was no credit against the purchase price for the money tendered. They also agreed to pay market rents even though this meant annual rent increases. I secured motivated, mannerly tenants who have guaranteed me no vacancy or repair problems for years. They're living where they want in a decent house with assurance that they will never have to move. Why would I ever sell it? I won't.
We've been talking about Right of First Refusal Options only in the context of sales and purchases. I've found them a great aid in getting rental renewals. When I've interviewed and accepted a credit worthy tenant, I give them the choice of multi-year rentals which carry a limit on any rent increases to 10% per year regardless of market conditions. I'm offering the tenant a predictable housing expense to make my own income stream more predictable, but this also limits my ability to sell the property should an attractive offer come my way. I've got another problem that I'd also like to solve. State law in may states control tenant deposits to the extent that, practically speaking, they no longer secure the landlord at all and generate most of the small claims court actions when tenants sue to recover their deposits.
By getting the tenant to pay an amount equal to the deposit as consideration for a Right of First Refusal Option to RENT the property with the above stated 10% limit on rent raises over the period, I get the cash tax free as Option consideration until the tenant either exercises the Option or elects not to. I also avoid state controls over the money and can add it to my cash flow. And probably most importantly, I'm reasonably assured that I'll retain my tenant over a longer period of time – often multiple years. All I have to do at renewal time is to remind the tenant that he/she has already paid for the Option and that the money would be wasted if they failed to renew their rental contract.
This gives them a strong incentive to renew. But, If I were to have an opportunity to sell the property, since this is an Option that I control rather than the Tenant, I can go ahead and sell it. In this event I usually offer the Tenant a bonus equal to the Right of First Refusal Option consideration so he/she isn't damaged financially and can move on to other quarter whether provided by someone else or by me.
BEWARE: OPTIONS CAN BE HAZARDOUS TO YOUR HEALTH!
There are several flies in the ointment when it comes to using lease/Options, 'rent to own' schemes, and other similar devices. Courts in California have held these to be legal installment contracts. When the tenant fails to pay the rent, a mere eviction isn't legally sufficient to extinguish his/her rights. It requires a JUDICIAL FORECLOSURE unless the rental/Option agreement has been secured with a Deed of Trust with the right of sale incorporated in it. Moreover, in some instance, the arrangement has been considered to be subject to the various lending laws that abound. In some instances a mortgage lender's license has been required. The yield to the owner has been deemed to be interest regardless what it has been termed in the contract between owner and tenant, and therefore subject to usury laws. You need to examine the case and statute law in your area to be certain you don't run afoul of these problems where you live.
There's one more hazard to be aware of: Sometimes the tenant exercises his Option and you are forced to sell a pretty good house that you'd rather have kept. That has happened to me five times over a long career as a landlord. Each time the closing was held in December, completely upsetting my tax planning. That's the bad news. The worse news is that I had to go out and replace the property, which required some degree of effort on my part. The remedy is obvious. First of all, don't grant anything but First Right of Refusal Options on properties that you want to keep. If you're stumped trying to overcome net operating income problems, set the time as far out as possible and the price at the then appraised value. Make the terms all cash. This might dissuade the tenant from exercising the Option too early. Be sparing about how much credit is given for rents against the down payment and purchase price.
There's one more little device which will enable you to use lease/Options and still keep your property. Let's say that the tenant is more interested in securing a stable living arrangement at a price he/she can afford and building equity through payment of higher rents than in buying a particular house in a particular neighborhood. Let's face it, except in times of lower interest rates such as we're seeing today, rents are usually a lot lower than mortgage payments.
There are many reasons why a person would just as soon not buy when rents are higher. Suppose today you granted an Option for 5 years at the $825 in our original example – $75 over current market rents. Over the 5 year period, the tenant would have built up an equity of $6000 as discussed previously. You might build a disincentive right in the middle of your Option which says you'll return $3000 to the tenant at the end of 5 years in the event he/she decided NOT to exercise the Option.
Let's assume that the $100,000 house is now a $125,000 house at the end of 5 years. Let's say the lender requires 10% down payment and that interest rates have risen to 12% (Would you like to bet that they'll be lower?) That means your tenant will have to come up with an additional $6500 in cash for the down payment plus a couple thousand for closing costs. His/her payments on the remaining $112,500 would be $1157.19 plus taxes and insurance. That's over $300 more than it's been costing for rent for the past 5 years. On the other hand, he/she can surrender the Option and receive $3000 in cash – and continue to live in the house afterwards at current market rents.
Can you see that there would be a strong motivation to let the Option expire rather than to exercise it? From the standpoint of the owner, he or she would have been receiving $900 per year in extra cash flow and will have had to return only the equivalent of $600 per year. Meanwhile he/she would have experienced no vacancies, repair costs and above average net operating income over the period. Options which combine higher rents with the tenants paying for all repairs are the bees knees. But what about increasing net operating cash flows when rents can't be increased and when nobody want an Option?
A PENNY SAVED CAN BEAT A PENNY EARNED . . .
Suppose you earned $100 net after taxes. To arrive at that, you'd at least have to have paid taxes, and in the lowest bracket without any state income taxes it would still require that you earn $115 to realize the additional $100. Instead, suppose you were able to save $115. Admittedly, you'd lose the 15% benefit that a tax deductible expense would have provided, but you'd still have more than $100 left in your hands after taxes. While rents come first, thrift and prudence follow right behind in increasing net operating income. Here are some management tips to help you save management money.
First, pass on as much expense as you can to your tenants. It's a lot cheaper to waive a deposit in return for the tenant's cleaning and painting a house. Suppose that would cost you $1000 if paid for in cash. You could probably buy enough paint and cleaning supplies to do the job for about $200 in most areas. If you could waive a $500 deposit, spend $200 and save $1000 in cash, that would certainly help improve your bottom line. Each month around the 20th we send a rebate coupon to the tenant which can be redeemed for about 15% of the rent so long as all repairs are completed and the rent is received no later than 5PM on the last day of the month. We also follow up with one scheduled and one unscheduled inspection to be certain that these repairs are being made. In theory, this is a beautiful system. In practice, it doesn't work as well as it could mainly because our property managers and inspectors don't enforce it routinely. It's hard to pay people to supervise tenants when it's not their money that's being spent. Still, this system has worked fairly well for almost 20 years in one form or another.
Another area in which we save money is by not providing kitchen appliances. Tenants have the option of buying or renting their own (from us or from 3rd party vendors), or of accepting marginal appliances in various stages of attractiveness and cleanliness that we can provide without any guarantee by paying an additional $5 per month per appliance. Conversely, if we can remove an appliance because they prefer to provide their own, we deduct the same $5 per month. Either way, we remove a major bone of contention and liability for spoiled food – and the need to service appliances at high hourly rates. From time to time we've been able to provide financing for a tenant's appliance purchase, making a profit both on the appliance and on the financial arrangements. All this goes directly to bottom line income.
You can combine maintenance with Options to achieve about the same results as if you'd combined a lease with an Option. Think of it this way: Suppose all gross income from a rental were like water in a bucket. Income fills it up, but expenses are like a leak in the bottom which drains income back out. When you increase gross income, it fills the bucket. That does you little good if it all runs out the bottom. When you add an Option, that just fills the bucket a little fuller. On the other hand, even if you were not able to increase the income flow into the bucket, but were able to reduce the flow out the bottom at no cost simply by giving a maintenance company an Option to buy the property in return for free or bargain priced maintenance support, you'd accomplish the same result: more water/net income in the bucket. Good luck for the coming year.
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